While the proposal may have been motivated by concerns around large debt outflows, the timing of its issuance is important for another reason. The short term debt market in India has been facing liquidity problems in the wake of a series of defaults by the non-banking finance company, Infrastructure Leasing & Financial Services Limited (IL&FS). The presence of FPIs in the market is an additional source of liquidity. At such a time, it is important to carefully consider measures for liberalising FPI flows in the short term onshore debt market.

The RBI's proposal to conditionally liberalise FPI flows into the Indian debt market raises several questions, which we elaborate upon in this article.

Uncertainty in regulatory framework governing foreign debt inflows

The regulatory framework governing foreign inflows in the onshore debt market has undergone several changes in the recent past. Prior to February 2015, FPIs were subject to an aggregate equivalent of USD 51 billion cap when investing in the onshore debt market. Sub-limits were allocated to debt instruments of various tenure (such as commercial paper, other short-term bonds and longer-tenure instruments).

In February 2015, RBI prohibited FPIs from investing in onshore debt with less than 3 years maturity. Dutt, Pattanaik and Zaveri (2016) conducted an impact analysis of the debt-portfolios of FPIs in the post-intervention period. Their study did not find any evidence of the FPIs increasing their participation in long term bond holdings after the intervention, or any change in the average period for which FPIs hold the debt.

In June 2018, RBI relaxed this requirement for FPI investment in government securities (G-secs). For corporate bonds, RBI diluted the requirements by allowing FPI investment with a maturity period of less than 3 years but more than 1 year.

In the October 2018 discussion paper, RBI has proposed to create a new route of investment called the Voluntary Retention Route ("VRR") to attract long term FPI flows into onshore Rupee denominated debt. The new proposal dispenses with the June 2018 prohibition on investing in corporate bonds of less than 1 year maturity. In doing so, the new proposal seems to suggest that the existing regulatory prescriptions governing FPI investment in onshore debt are onerous. Easing them would incentivise foreign investors to retain investments in India.

Foreign investors look at financial returns when deciding to invest in a country. They also look at the extent of clarity and certainty in the regulatory and macroprudential framework of the host country. The frequent changes in the regulatory framework governing FPI investment in debt over the last 3 years create uncertainty.

The new proposal

The VRR framework proposed by the RBI imposes the following restrictions on FPI investment:

Cap on investment: The total amount to be invested will be decided by the RBI from time to time based on macroprudential considerations.

Cap per FPI: The limits decided by the RBI under item 1 will be allocated to each FPI on the basis of an auction. The amount that each FPI bids in each auction is referred to as the "Committed Portfolio Size, or CPS".

Lock-in or retention period: For all investments made under this route, there will be a minimum retention period of 3 years or any other lock-in period as decided by the RBI. This may vary each time fresh investment limits are auctioned. In every auction, the bidding FPI must propose a "retention period" and the minimum amount it proposes to invest. The retention period must not be less than the retention period prescribed by RBI for that specific auction. Bids will be accepted in descending order of the retention period proposed in a bid - that is, the bid with the least retention period will get the last preference. During the retention period, the FPI must retain atleast 67% of its investment, on an end-of-day basis.

Minimum investment: Each FPI will be required to invest 67% of the CPS within one month of the announcement of the auction result.

The objective of the VRR scheme seems to be to provide operational flexibility to foreign investors in terms of instrument choices. The scheme also provides exemptions from regulatory prescriptions if the investors commit to retain a part of their investments in debt securities in India.

Cost of borrowing

The proposal may disincentivise FPIs from investing in India and raise the cost of borrowing for Indian firms that seek to access the debt market.

A foreign investor will prefer an investment option which gives him liquidity i.e. the ability to cash out when he needs to. If, on the other hand, the investment option is such that the investor will be locked in even when he has compelling reasons to exit (such as a change in his India-outlook or his own need for liquidity), then he will have less incentive to consider such an illiquid investment. In order to do so, he will demand an 'illiquidity premium'. The required rate of return in an illiquid asset is higher.

FPIs form a significantly large percentage of institutional investors in corporate bonds. The demand for a liquidity premium will raise the overall cost of borrowing in an already illiquid fixed income market. This would be equally applicable to G-secs.

Economic rationale

The economic rationale for imposing restrictions on foreign debt flows into local currency denominated instruments is not clear. It is possible that this new route has been proposed to arrest the sharp depreciation of the Rupee that has accompanied the capital outflows from Indian debt market in recent months. However, Pandey, Pasricha, Patnaik and Shah (2016) show that capital flow measures on debt used previously in India have not had a significant impact on exchange rate.

The Report of the Committee to Review the Framework of Access to Domestic and Overseas Capital Markets (also known as the Sahoo Committee Report on External Commercial Borrowings) explains that systemic risk is limited to situations where the currency risk is borne by the resident and remains unhedged. This risk arises due to currency mismatches at the time of repayment. This is not the kind of risk associated with foreign investment in Rupee debt.

The discussion paper does not provide the rationale for the specific conditions imposed on the investments made in the VRR route. For instance, the requirement that 67% of the committed investment amount must be locked-in during the retention period, may come across as arbitrary. There is no clarification as to why this percentage, and not any other, has been specified, or why a 3-year lock-in period has been chosen. The condition that the FPI may choose to exit during the lock-in period by selling only to another FPI (and not to any domestic buyer) has also not been explained either.

Utility of the scheme

The utility of the proposed VRR scheme is not clear for the following reasons:

The proposal states that "investments through the Route will be free of the macro-prudential and other regulatory prescriptions applicable to FPI investments in debt markets". It is not clear what macroprudential prescriptions the investments in the VRR route will be exempt from. In some cases, the exemptions from the regulatory prescriptions may be redundant.

For example, the existing minimum maturity restriction (i.e. the condition that an FPI must invest in securities having a minimum maturity period of atleast one year) is relaxed for investments under the VRR route. This relaxation may not be meaningful because under the VRR scheme, the foreign capital will, in any case, be locked in for the period mandated for that specific auction. There could be a scenario where an FPI uses this route to invest in instruments with a maturity period of less than one year. Since 67% of its CPS is locked in, it will be compelled to reinvest a significant part of its committed portfolio in short-term instruments. This may dilute the intent of the proposed VRR scheme.

There is also no evidence of a growth in demand for longer-term debt among FPIs. On the contrary, there is evidence that prior to the restrictions introduced from 2015 onwards, there was significant FPI interest in the debt market with a maturity profile of less than three years. Pandey and Zaveri (2016) argue that prior to February 2015 when FPI investment in short-term debt was allowed, the utilisation by FPIs of the debt limits for commercial papers (CP) was about 95 per cent, while the utilisation of the debt limits for corporate bonds was about 69 per cent. The demand for commercial papers reflects the interest of FPIs in short-term Rupee-denominated debt.

Bidding for the general limits as specified by the RBI for corporate bonds and G-secs, is a relatively simpler process as they do not have the additional complexity of indicating a retention period.

Costs of monitoring and enforcement

There are potential operational issues in the VRR proposal that can hinder monitoring and enforcement of the caps and limits stipulated under it.

For example, the proposal states that the FPIs eligible and opting for the VRR scheme will be exempt from the existing restrictions such as the restrictions on investment in short-term debt. Given that the minimum retention period will be three years, it is not clear how this exemption will be implemented in practice. It is also unclear how the retention of 67% of CPS during the lock-in period will be enforced and monitored. India has already had experiences in the recent past where monitoring lapses have resulted in reversal of trades on exchanges, thereby eroding the sanctity of exchange-traded contracts (see here).

Rule of law

The VRR proposal is ambiguous on important aspects that potentially feed into the decision making process of a foreign investor. A foreign fund seeking to invest in an emerging economy looks at the contours of the regulatory framework that will govern its entry, exit and its investment during the holding period. Clarity of the law, certainty and a rule-based (as opposed to a discretion-driven) system are critical elements of rule of law that would matter to the foreign fund. The VRR proposal on the contrary, leaves critical terms and conditions to the discretion of the RBI.

For example, the proposal does not offer clarity about whether this is a one-time route or a new permanent feature of the regulatory framework governing foreign debt inflows in India. The quantum of limits and the intervals at which the limits will be auctioned are not clear. The proposal states that the lock-in period is three years, or as decided by RBI for each auction. In other words, critical aspects of the framework, such as the aggregate limits, the per-auction limit, the intervals with which the auctions will be conducted and the lock-in period for each auction, have been left to the discretion of the RBI.

The proposal seems to implicitly suggest that once the terms and conditions of a specific auction are announced, FPIs will plan their affairs to make themselves eligible for such auction. This approach may not be consistent with the manner in which foreign funds decide to invest in an economy. It is possible that dedicated funds do not have the flexibility to modify their investment horizon at the time of the auction to meet RBI's requirements.

Structural reforms are the way forward

A stable foreign exchange regulatory framework based on sound economic principles, will help the country attract more and longer-duration foreign investment inflows. Investors are willing to make long-term bets on stable economies where they are assured of clarity, certainty and the rule of law. Reaction by the authorities to sudden capital outflows and currency volatility may complicate an already fragmented landscape.

The proposal of the VRR route of investment seems symptomatic of the central planning approach that has long pervaded the regulatory policy governing capital flows into and from India. Despite being described as `voluntary', the proposal leaves all decisions to the discretion of the regulator.

In the last decade, India had taken some decisive steps towards structurally reforming its capital controls framework. For example, a big milestone was the shift from absolute quantitative caps to phased percentage-based relaxation of limits for FPI participation in G-secs (see here). Such a phased approach gives clarity to FPIs on the future capital account opennness of the onshore debt market, and allows them to plan their affairs with greater certainty. Similarly, considerable work was done at the Ministry of Finance in thinking about and recommending structural reforms to the framework governing capital controls (see here and here).

Subsequently, several steps taken by the policy makers to respond to immediate circumstances as highlighted at the start of this article, have further complicated an already prescriptive and fragmented legal framework for foreign participation in Indian debt. The latest proposal of the VRR route of investment may have a similar regressive effect.

The strategy towards foreign investor participation in debt securities needs to be fundamentally modified to overcome home bias. In the literature on international finance, greater capital account openness aids in overcoming home bias. Micro-management of the capital account framework deters foreign investors from engaging long term with the host country. Country experiences suggest that the impact of capital flow measures is ambiguous and at best temporary (see here and here). The need of the hour is to resume the path of deeper structural reforms and abandon quick-fix proposals.

Radhika Pandey is researcher at National Institute of Public Finance and Policy, New Delhi. Rajeswari Sengupta and Bhargavi Zaveri are researchers at Indira Gandhi Institute of Development Research, Mumbai.

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